October 27, 2013 6:57 pm

Beijing’s caution on reforms makes sense – for now
But China does not have the luxury of deferring all changes until conditions suit, says Eswar Prasad
Paramilitary policemen hold their fists in front of a flag of Communist Party of China©Reuters
Cataloguing China’s economic risks has become a popular parlour game. In the past decade, a steady drumbeat of warnings has predicted imminent collapse. Rising state and local government debt, a weak financial system and multiplying inefficiencies in the economy certainly pose big risks. The reforms needed to maintain growth and improve its quality have been painfully slow.
Despite these problems, the size of China’s economy and the per capita income of its citizens have quadrupled in the past 15 years, pulling millions out of poverty. Still, the country cannot outrun its problems forever. Unbalanced growth has led to widening inequality and environmental degradation.
China’s leaders often talk of the need for broad reforms but their actions are, critics say, plodding and hypercautious. This issue is in the spotlight as expectation builds that next month’s party plenum in Beijing will yield a range of reforms. Some warn, however, that such hopes will be disappointed.
Yet, for all the criticism, certain aspects of China’s cautious approach to economic reforms, which is likely to continue, might actually prove an object lesson to other countries.

Consider the proposal to eliminate the ceiling on interest rates paid on bank deposits. The ceiling has stifled competition among lenders, resulting in households receiving minuscule real returns on their deposits for much of the past decade.

Removing the ceiling would have its dangers. Weaker, poorly regulated banks might offer higher rates to compete for deposits, make riskier loans and set themselves up for failure. An explicit deposit insurance system, rather than the implicit state guarantee that now covers all deposits, would impose market discipline.

Since such a system would take time to put in place, the government has chipped away at the ceiling by allowing the proliferation of other saving products with higher returns. This approach has its own risks but helps catalyse interest rate reforms.

Small, indirect changes, even if inefficient, elicit less opposition, pose fewer risks and make course corrections easier. A big-bang approach might harm the cause of reform in the long term by inviting stronger opposition from those keen to maintain the status quo.

Many countries have undertaken big changes when they face a crisis; reforms are harder without such pressure as they invariably involve disruption and risks. The rhetoric surrounding proposed measures then turns out to be crucial in determining their political fate. In the US, the benefits of the Affordable Care Act have been subverted by the false narrative that it would socialise healthcare and destroy jobs.
In emerging markets, the notion that reforms benefit the economic and political elite is a powerful obstacle. Foreign investment in India’s retail sector has been stymied by the narrative that it profits global corporations, destroying small retailers’ livelihoods. In reality, it would help the poor by improving food distribution channels, reducing waste and keeping costs down.
Beijing has proved effective at creating narratives that build broad support and provide a framework for communicating the logic and desirability of individual reforms.

Given its under-developed financial markets, capital account liberalisation would be premature. But this objective highlights areas where reforms would be in China’s own interest: broader and better regulated financial markets, as well as a more flexible exchange rate.

This year, Beijing announced a plan to reduce inequality. This would be a dubious policy goal if it emphasised redistributive policies. In fact, the proposals are exactly the reforms neededfinancial market liberalisation, reform of state-owned enterprises and freer labour mobility. All are worthy in themselves but the narrative helped emphasise that the benefits would be widespread rather than accruing to the select few.

Narratives must be translated into action. China does not have the luxury to postpone all reforms until the conditions are ripe. Its leadership may have to take greater risks to advance much-needed steps. But critics should appreciate that Beijing’s approach might reflect its economic and political savviness rather than a lack of commitment.

The writer is a professor at Cornell University, a senior fellow at the Brookings Institution and a former head of the IMF’s China division


Copyright The Financial Times Limited 2013.

October 27, 2013

The Big Kludge



But while we wait for the geeks to do their stuff, let’s ask a related question: Why did this thing have to be so complicated in the first place?
It’s true that the Affordable Care Act isn’t as complex as opponents make it out to be. Basically, it requires that insurance companies offer the same policies to everyone; it requires that each individual then buy one of these policies (the individual mandate); and it offers subsidies, depending on income, to keep insurance affordable.
Still, there’s a lot for people to go through. Not only do they have to choose insurers and plans, they have to submit a lot of personal information so the government can determine the size of their subsidies. And the software has to integrate all this information, getting it to all the relevant partieswhich isn’t happening yet on the federal site.
Imagine, now, a much simpler system in which the government just pays your major medical expenses. In this hypothetical system you wouldn’t have to shop for insurance, nor would you have to provide lots of personal details. The government would be your insurer, and you’d be covered automatically by virtue of being an American.
Of course, we don’t have to imagine such a system, because it already exists. It’s called Medicare, it covers all Americans 65 and older, and it’s enormously popular. So why didn’t we just extend that system to cover everyone?
The proximate answer was politics: Medicare for all just wasn’t going to happen, given both the power of the insurance industry and the reluctance of workers who currently have good insurance through their employers to trade that insurance for something new. Given these political realities, the Affordable Care Act was probably all we could get — and make no mistake, it will vastly improve the lives of tens of millions of Americans.
Still, the fact remains that Obamacare is an immense kludge — a clumsy, ugly structure that more or less deals with a problem, but in an inefficient way.
The thing is, such better-than-nothing-but-pretty-bad solutions have become the norm in American governance. As Steven Teles of Johns Hopkins University put it in a recent essay, we’ve become a “kludgeocracy.” And the main reason that is happening, I’d argue, is ideology.
To see what I mean, look at the constant demands that we make Medicarewhich needs to work harder on cost control but does a better job even on that front than private insurersboth more complicated and worse. There are demands for means-testing, which would involve collecting all the personal information Obamacare needs but Medicare doesn’t. There is pressure to raise the Medicare age, forcing 65- and 66-year-old Americans to deal with private insurers instead.
And Republicans still dream of dismantling Medicare as we know it, instead giving seniors vouchers to buy private insurance. In effect, although they never say this, they want to convert Medicare into Obamacare.
Why would we want to do any of these things? You might say, to reduce the burden on taxpayers — but Medicare is cheaper than private insurance, so anything taxpayers might gain by hacking away at the program would be more than lost in higher premiums. And it’s not even clear that government spending would fall: the Congressional Budget Office recently concluded that raising the Medicare age would produce almost no federal savings.
No, the assault on Medicare is really about an ideology that is fundamentally hostile to the notion of the government helping people, and tries to make whatever help is given as limited and indirect as possible, restricting its scope and running it through private corporations. And this ideology, at a fundamental levelmore fundamental, even, than vested interests — is why Obamacare ended up being a big kludge.
In saying this I don’t mean to excuse the officials and contractors who made such a mess of health reform’s first month. Nor, on the other side, am I suggesting that health reform should have waited until the political system was ready for single-payer. For now, the priority is to get this kludge working, and once that’s done, America will become a better place.
In the longer run, however, we have to tackle that ideology. A society committed to the notion that government is always bad will have bad government. And it doesn’t have to be that way.

Draghi Risks Having Worst of All Worlds

By   Simon Nixon

Updated Oct. 27, 2013 7:19 p.m. ET


The euro zone's decision to create a banking union is in many respects as momentous as the creation of the euro. After all, bank supervision involves interfering in how resources are allocated—indeed, sometimes violently so when it comes to apportioning losses in failed banks. This is the essence of politics, a role that goes to the heart of sovereignty.

The ECB has never shied from spelling out the full significance of a banking union. But the same can't be said of many politicians across Europe. They have been only too happy to present its first stage—the creation of a single supervisory mechanism based at the ECB—as just another step in the evolution of Europe's single market, certainly nothing to trouble voters about.

But this gap between reality and rhetoric (or lack of it) will have to be bridged at some point. Will the euro zone acknowledge the banking unions' political implications at its birth? Or will it wait until the next crisis to grapple with the consequences, as it did with the euro?
So far, there is no clear answer. This became obvious last week when the ECB published its guidelines for a "comprehensive assessment" of the 124 largest euro-zone banks.

The ECB faces a binary choice over how it handles this assessment, which it hopes will restore trust in the banking system before it takes on its new supervisory powers in November 2014. Until the ECB decides which way to jump, the euro zone faces months of political—and potentially financialvolatility.

The ECB can opt for a maximalist approach that addresses the major structural weaknesses in the banking system that are contributing to an alarming collapse in lending: low profitability, reliance on central-bank funding, poor quality of capital. This would likely lead to a significant restructuring of the banking system, including substantial recapitalization. But it also requires tough rules to deal with banks that fail the test and a credible backstop to maintain the confidence of markets.

The alternative is a minimalist approach aimed only at boosting confidence in the accuracy of bank disclosures and demanding limited capital raising where new harmonized rules on bad debts reveal shortfalls, but leaving the industry's structure broadly unchanged. However, this approach depends on the ECB providing a new cheap funding facility to replace the two long-term refinancing operations that expire at the end of next year, thereby giving banks more time to earn their way out of trouble.

Both options remain on the table, reckons Nicolas Veron, a senior fellow at the Brussels-based think tank Breugel.

  The range of risks the ECB says it will assess is indeed comprehensive, including exposure to sovereign bonds and hard-to-value market assets, as well as risky funding structures and overall leverage. But crucially, there was no detail on methodology.

Similarly, the baseline capital requirement has been set suspiciously low, says Alasdair Ryan, an analyst at Bank of America Merrill Lynch. Banks must achieve a minimum 8% core Tier 1 ratio under Basel III rules, but can take advantage of transitional arrangements allowed under European law. The current euro-zone average on this measure is 12%. But what will determine the scale of any capital raising are the details of the stress tests, which may not be known for several months.

One reason for the lack of detail is that ECB has yet to appoint its new supervisory board, which will lead the assessment.

But the lack of detail also reflects the political pressure the ECB is under from national governments pushing hard for a minimalist approach, emboldened by evidence of growing investor interest in buying distressed assets from crisis-country banks.

The ECB fears the long-term risks of this approach. If undercapitalized banks continue to invest in government bonds rather than extend new loans, the euro zone will face a slower recovery.

Worse, continued heavy government bond-buying by banks will weaken incentives for governments to pursue fiscal discipline, intensifying the link between sovereigns and banks. And any revival of cross-border flows of capital and liquidityone of the most eagerly anticipated benefits of a common supervisor—will raise the political stake in the event of a future bank failure.

No one should underestimate ECB President Mario Draghi in this battle, says Mr. Veron. He has shown he is a street-wise political fighter, not least in securing the euro zone's commitment to a banking union as the price of the ECB's agreement to support government bond markets.

But the odds are stacked against him. All decisions of the supervisory board—which some estimate could number 10,000 a yearmust be ratified by the ECB's Governing Council, providing plenty of scope to push national agendas as each euro-zone member has a seat on the council for its central-bank chief. The ECB will also remain constrained by national laws and its continued reliance on national authorities as it builds up its own supervisory staff to a planned 1,000 from 100 today.

Nor can Mr. Draghi count on political support for a maximalist approach. German Chancellor Angela Merkel has effectively reneged on her June 2012 commitment to allow the European Stability Mechanism to invest directly in banks, fearing it would be used as a first rather than last resort. Similarly, Germany has been wary of creating a robust single-resolution mechanism, perhaps fearing it could be used to close down German banks.

Meanwhile any attempt to put the banking union on a more robust legal footing would require changes to euro-zone treaties, triggering U.K. demands for a wider renegotiation of the workings of the European Union that could paralyze EU policy-making for years.

The ECB risks ending up with the worst of all worlds: responsibility but not power, obliged to preside over a banking system seemingly unable to escape its flawed past. As with the euro's creation, the solution may have to wait for the next crisis.

Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved

Peru ETF Gets Some Ratings Agency Help

The iShares MSCI All Peru Capped ETF (EPU) strengthened after Fitch Ratings upgraded the country's credit rating, praising the economy's ability to absorb shocks in the system.

The fund gained 5.5% over the past three months, but is still down 23.4% year-to-date.

Fitch raised Peru's foreign-currency rating to BBB+ from BBB as the higher rating better reflected the country's ability to withstand slower global growth, reports John Quigley for Bloomberg. Anything BBB- or higher is considered investment grade quality.

"Peru's established track record of policy coherence and credibility as well as the sovereign's fiscal and external financing flexibility underpin its strong shock absorption capacity," Fitch said.
President Ollanta Humala is maintaining the government's "pragmatic approach" to private investment. Additionally, Humala's "conservative" policy could bolster fiscal surplus for the third consecutive year and cut debt to 19% of GDP from 20% in 2012, according to Fitch.

"Continued pragmatism under the Humala administration and a steady progress on reforms suggests that the risk of a marked departure of economic policies has reduced," Fitch added.

Peru's economy is expected to expand 5.4% this year, down from 6.3% in 2012 due to the drop in prices in metals. Fitch, though, believes Peru can still outperform BBB-ranked economies, like Brazil, Panama and South Africa.

EPU, the lone Peru-specific ETF, allocates 46.5% of its weight to the materials sector and that makes sense because the country is the world's largest silver producer and the fifth-largest gold producer. Consequently, the fund shows a higher correlation to precious metals.

Earlier this month, a report released by the World Gold Council and PricewaterhouseCoopers illustrated just how important gold is to the Peruvian economy. The report uses gross value added (GVA), which measures the contribution to gross domestic product (GDP), employment and taxes paid as a metric for measuring the impact of gold output on major gold producers' economies.

Direct GVA from gold mining in Peru is estimated to be $8 billion, according to the report. "The average amount of economic value added per ounce of gold is US$1,139 and ranges from US$946 in China to US$1,352 in Peru in 2012. The differences between countries reflect variations in labour costs and productivity," the report noted.

iShares MSCI All Peru Capped ETF

(click to enlarge)
Max Chen contributed to this article.

October 26, 2013

Eugene Fama, King of Predictable Markets



Eugene F. Fama, 74, is one of the winners of this year’s Nobel Memorial Prize in Economic Science, along with Lars Peter Hansen, a fellow professor at the University of Chicago, and Robert J. Shiller, a professor at Yale.
Often known as the father of the efficient-markets theory, Professor Fama, a former student of Milton Friedman, the University of Chicago Nobel laureate, is a careful empiricist and a genial, open conversationalist. But some of his opinions have set off controversies. He has come under criticism from Professor Shiller, for example, for minimizing the role of investor psychology and emotion in financial markets.
And while Professor Fama doesn’t involve himself directly in politics, saying his “extreme libertarianviews are of no general interest, he isn’t reticent when asked about them. I interviewed Professor Shiller, a frequent contributor to Sunday Business, for an article last week. And on Tuesday, I talked by phone with Professor Fama for more than an hour. Here is an edited, condensed version of that conversation
Q. Gene, great to talk to you again. Congratulations.
A. Thank you, Jeff.
How are you celebrating? Are you getting out on the golf course these days?
Oh, yeah. I have a new hip; I’m a new man! If anybody ever tells you that you need a new hip, don’t hesitate.
O.K., I’ll keep that in mind. Now some serious business: help me explain your work and your views to people who don’t know them. Let’s start with the efficient-markets theory — or hypothesis, as you call it. What do those words mean?
Well, the general proposition is quite straightforward. It says prices reflect all available information. That’s it. The difficult part comes in developing tests of that idea, but the idea itself is quite simple.
Put that way, it seems like an insight that everyone has always had. But was that really a new thought?
You’re right, I didn’t invent the idea. Definitely not. I coined the termsefficient markets” and “market efficiency.” You’ll find them in a paper I wrote in 1965. But those are just words.

What I did that was more substantive was I pointed out that you can’t test the hypothesis without also setting out what we call a “model of market equilibrium.”
What does that mean?
In simple terms, it’s this: you’ve got to ask what is the market trying to do in setting prices. In more detailed terms, what it says is: tell me something about how to measure risk. And then tell me, what is the relationship between the expected return on an asset and its risks. It’s a combined problem, something I call the “joint hypothesis problem.” You’ve got to test them together. And testing all of that is where it gets tricky.
The idea is that market prices in the short term don’t have a predictable direction. One implication of this thinking is that it’s very hard to beat the overall stock market, which is an argument for low-cost index funds as opposed to active management. True?
Yes. That’s right.
But then your own research undercut some of this. When you looked closely, you found that markets were more complicated. You looked at bond returns, and found that there actually was some predictability, right?
Yes! And Shiller and I and lots of others wrote papers and found a similar phenomenon with stock prices.
You found some factors that may help to predict longer-term stock prices.
Well, yes, take something like the dividend-stock price ratio. When it’s high, expected stock returns tend to be high, and when it’s low, expected returns tend to be low.
And then Ken French [a Dartmouth economist] and I wrote a paper saying that for both bonds and stocks, there are several variables that affect prices, all of which are highly related to business conditions. We concluded that it tells us that it’s likely that the variation in expected returns is rational.       
Richard Thaler, your good friend at the University of Chicago, and Bob Shiller, your fellow Nobel laureate, take a different view.
The people on the other side say, well, not so quick! The variation in expected returnseven if it’s related to business conditions — can be irrationally related to business conditions.
So which is it, rational or irrational? Do you know?
Well, at that point, you cannot tell the difference anymore between the behavioral and the rational explanations.
Shiller and Thaler helped to found the field of behavioral finance to help explain a lot of these anomalies. Where’s the difference between the two views, as you see it?
If I were to characterize what differentiates me from Shiller or Thaler, it’s basically we agree on the facts — there is variation in expected returns, which leads to some predictability in returns. Where we disagree is whether it’s rational or irrational. And there’s nothing in the available evidence that allows one to really settle that in a convincing way.

The stuff that both Shiller and I have done has been very illuminating in terms of the behavior of returns. The interpretation of that is open for reasonable disagreement.
I think all points of view should get a full airing, and that’s why I’m thrilled to get the prize with Shiller.
That’s a great summary.
But all of the common asset pricing models are based on the concept of market efficiency. That’s the other part of the story. 
I’ve spent a good part of the last 40 years testing those models. And a result of a lot of that is the so-called Fama-French three-factor model. It’s widely used both by academics and in industry. [He chuckles.] I’m laughing because the theoretical basis for the model is quite shaky. Basically, we saw these patterns in returns and our motivation was to try to explain them.
Unlike Shiller, you believe there’s a rational basis for all this stock behavior. What are the three factors, as you see them?
The spread of the market return over the Treasury bill rate is one factor. The second is the small-stock factor — the difference in the returns of small stocks and of big stocks. And then there’s the so-called value-growth factor, which is the difference between a diversified portfolio of value stocks versus growth stocks.
Your research has played a big role at Dimensional Fund Advisors, which has become a major asset management company. You were there at the beginning, weren’t you?
Oh, yes, I’ve been on their board since their first day, and my work is embedded in a lot of their products, sure.
Now let’s focus on a few other touchy subjects. Bob Shiller has been recognized by the Nobel committee for his work on asset bubbles. But if I ask you what caused the financial crisis — was it an asset bubble, a real estate bubble — you’re going to tell me you don’t even know what a bubble is. Is that right?
[He laughs] Yes! Absolutely right!
Now let me ask you, have you ever testified before Congress or given policy advice to political figures?
No, I’m too unpredictable. I don’t give advice like that. I don’t believe anyone wants to hear what I have to say.
Why’s that?
Well, I’m an extreme libertarian, but I realize we’re in a democracy, and in a democracy people can have views of all stripes and there’s no reason to argue about it.
Well, you’re a Nobel laureate now and people are curious about your views. For example, whenever we talk you always seem to be rereading “The Road to Serfdom,” by Friedrich Hayek. That’s an important book for you, isn’t it?
Yes, it’s a great book. It’s a philosophy, of course; it’s not empirical. What Hayek is basically saying is that to the extent you let government take over economic activity you’re basically giving up freedom, and I think that’s a point Milton Friedman made quite emphatically throughout his lifetime. 
I consider myself closer to Milton in my thinking than to anybody else. And Milton was also an enthusiastic libertarian.
Do you accept the basic teachings of John Maynard Keynes, which tell us that government should spend more to counter the effects of a recession?
No, I don’t think there’s a lot of empirical evidence that Keynesian spending really helps.
Despite his advocacy of smaller government, Hayek believed in a social safety net. Do you?
Yes, he did, and I have a similar view. I think we need Social Security, things like that.
And, of course, people don’t entirely understand how risky investing is. That’s very important to get across. We don’t really know if the stock market will produce the returns in the future that people expect.

Statistically, you can’t show that it will. There’s real risk there.
Do you believe in financial regulation?
Of course, some regulation, yes. You need a level playing field, you need the government to step in sometimes. But I think we’ve gone too far with Dodd-Frank.
In the financial crisis, do you think the government should have bailed out the big banks?
No, I don’t. I would’ve favored nationalizing the banks, not bailing them out.
Really? That’s not very libertarian, is it?
Well, we’re talking about realistic alternatives. It’s not credible that in a financial crisis, the government will do nothing. It never has. There are going to be demands for it to do something. So you’ve got two choices now. Nationalize them or bail them out. Bailing them out gives them terrible disincentives; it encourages them to take risks because they’ll be bailed out. So I’d nationalize them — and clean them up and then reprivatize them.
So would you have favored that the government do nothing at all?
I said at the time that it would be an interesting experiment. But what people argue is that it would be quite destructive, that it would create long-term problems. We don’t know that that’s true, but I think it’s kind of moot because it’s not an experiment that’s ever going to be run.